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Thursday, January 28, 2021

Academic Finance Destroys Yet More Capital

The recent equity market shenanigans has confirmed one of my biases: modern academic finance has been very good at destroying capital. If one were of a conspiratorial bent, one might guess that finance faculties were being secretly backed by the enemies of capitalism. (I have been currently watching a documentary series on secret societies, and such misdirection is not unprecedented.) The simultaneous advocacy of efficient markets as well as the ability of hedge funds to continuously outperform created the backdrop for short squeezes that even gamers can participate in.

Underlying Beliefs

The recent short squeeze in certain equities is quite remarkable, but the only somewhat surprising angle is how the hedge funds that imploded set themselves up. I am not an equity expert and I am reliant on media reporting, but I have seen it alleged that the short interest in some of the equities in question was 130% of the shares outstanding. This was obviously a very bad idea.

Furthermore, the ability to run up a share price is normally limited by existing holders exiting long positions. If equity management was dominated by long-term value managers, they could cap the gains on any equity of a reasonable size. (A penny stock with a tiny market cap will have too few such institutional holders, which is why penny stocks have always been synonymous with equity trading shenanigans.)

There are a few consensus beliefs from academic finance that explain why institutions developed in such a fashion to allow this to occur. To be fair, an individual finance professor might disagree with any or all of them. The problem with attempts to explain these away is that these are embedded in the finance industry. The finance industry is filled with finance students with advanced degrees, as well as ex-academics and academic consultants. In any event, the beliefs are as follows.
  • Markets are efficient, so portfolios should be mainly allocated to indexing (in some form), limiting the ability of portfolio managers to use their long-only balance sheet to lean against mis-pricings.
  • At the same time, some investors have skills that lead to steady outperformance of benchmarks -- alpha. (If one compares this point to the previous, all I can say is "consistency is the hobgoblin of small minds, etc.") One measures this by looking at short term returns and seeing whether they are consistently above benchmark. (The ugly reality is that the only instruments that offer that form of a return profile is short-term credit, or selling volatility.)
  • Following on the above, hedge funds are an "asset class" that offer high returns (courtesy of investment leverage).
  • We can analyse markets solely in terms of price; we do not need to worry about investors' balance sheets, margin or collateral calls, etc.
Taken together, these beliefs led to the institutional structures that led to the various squeezes.

Squeezes are Price Discovery

Despite the pious hand-wringing by some commentators, squeezes are how markets normally operate. In dealer markets, the dealers continuously move prices to test the intestinal fortitude of investors with large risk positions (which the dealers can easily sniff out).  

The usual stance of concerned people is to tut-tut at any hint of impropriety in trading. According to them, investing is about the cold, logical calculation of fair value. Since some investors have had a shock introduction to gamer culture, I would add a new phrase to learn -- care bears. Care bears are players in multiplayer games who want to cooperate against in-game threats, and not advance by fighting against other players. As such, the usual narrative about retail investing can only be understood as an attempt to propagate care bear culture.

Can Squeezes be Stopped? 

Although popular imagination has been captured by the notion of a swarm of investors, any large active investor could engineer such a squeeze. (Allegations of such operations have shown up in the business press late last year.) Since there is only a single investor, it cannot be viewed as "coordinated."

As such, it would be hypocritical to pretend that squeezes alone make markets inefficient or can be stamped out. In this case, there is only legitimate concern -- what about the bagholders?

The Bagholders

Although it would be easy for large investors to engineer squeezes, this is not something they can safely do on a continuous basis (except perhaps for market makers, who would vigorously protest against insinuations of such behaviour). The problem is that you need to take on a large risk position to put on the squeeze -- which you then need to exit. Once others get wind of what you did, the hunter will become the hunted.

The trick to get around this problem is to engineer a horde of followers who enter into your positions after you have. You exit by unloading your positions on the followers. 

The problem is that fundamentals will eventually win out. The later followers are stuck with shares that are massively overvalued, and the supply of greater fools have run out.

Historically, regulators have put in place rules with respect to investment recommendations. The idea was to stop actors from inciting an army of bagholders behind them. The problem is that those regulations cannot be easily enforced on the modern internet. I have sympathies for this policy stance, but I am unsure whether there any clean solutions.

Other Remedies?

I have seen a number of suggestions that would allegedly eliminate such behaviour. I have doubts about most of them.
  • A financial transaction tax might put a damper on high-frequency trading, but they cannot stop a squeeze. Derivatives poses a serious problem for such a tax (discussed below).
  • One could try to protect retail investors from being bagholders, but doing so almost certainly takes away their ability to manage their own portfolios. They could be stuck with expensive, lousy investment vehicles (e.g., Canadian mutual funds with an expense ratio of over 200 basis points).
  • One could attempt to regulate or tax exchange-traded derivatives, but the risk remains that activity will migrate to the lightest touch legal jurisdiction. Taxing them is difficult, since products can be designed to minimise the tax burden. (E.g., if there is a tax upon swap notionals, create a non-linear product that is almost like a swap, but has a pay-off that is roughly equal to multiple of the vanilla swap of the same  "notional value.") Meanwhile, interest rate and foreign exchange swaps are critical hedging vehicles for the functioning of global corporations and banks. For example, do we want to return to an environment where banking system solvency is put at risk by a rate hike cycle? (Fans of Warren Mosler might suggest taking away the possibility of a rate hike cycle.)
Market participants will always behave like market participants, realistically all that can be done is create paternalistic protections for retail investors. If the prospect of shady investment strategies is personally upsetting, the remedy to deal with this is to be a boring long-only unleveraged investor. Your portfolio's market value can vary, but you face no collateral or margin constraints.

(c) Brian Romanchuk 2021


  1. I believe the shenanigans that the financial markets display are a function the gross mal-distribution of income and wealth. Deal with that and the rest of the nonsense will take care of itself.

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